Do limits to arbitrage explain the benefits of volatility-managed portfolios?

We investigate whether transaction costs, arbitrage risk, and short-sale impediments explain the abnormal returns of volatility-managed equity portfolios. Even using six cost-mitigation strategies, after transaction costs, volatility management of asset-pricing factors besides the market return generally produces zero abnormal returns and significantly reduces Sharpe ratios. In contrast, abnormal returns of the volatility-managed market portfolio are robust to transaction costs and concentrated in the most easily arbitraged stocks, those with low arbitrage risk and impediments to short selling. Moreover, the managed market strategy only provides superior performance when sentiment is high, consistent with prior theory that sentiment traders underreact to volatility.